A 1031 exchange is found in the Internal Revenue Code Section 1.1031. The tax deferral allows federal taxpayers, both U.S. and foreign, to postpone paying federal and state capital gains and recaptured depreciation taxes when selling and replacing property held in a trade, business or for investment. A 1031 exchange is an indefinite, interest free loan that can amount to more than forty percent of the sales price. The tax is ultimately due when the replacement property is sold unless another 1031 exchange is initiated.
1031 Exchange Background
For hundreds of years, goods were bartered and traded where horse and livestock trading were common place. When a horse of greater value was traded for a horse of lesser value, boot or something of value, was provided to equalize the trade. After income taxes were instituted, the federal government determined that it was unfair for the taxpayer to pay tax on the transaction if no boot was received. The theory supporting a 1031 exchange is if the taxpayer sells and reinvests their sales proceeds into another property, then the taxpayer’s economic position has not changed. As long as the taxpayer has acquired property equal to or greater than the property sold, then the taxpayer has not realized the gain to pay the tax.
The 1031 code that states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like-kind which is to be held for productive use in trade or business or for investment.”
1031 Exchange Requirements
No gain or loss is recognized implies that given a completed 1031 exchange, the realized gain or loss is not recognized or due on the disposition. If a loss is incurred on the sale, a twenty-five percent tax is still due on depreciation whether taken or not unless a 1031 exchange is completed.
Real and personal property, both tangible and intangible, are eligible for 1031 consideration. Any type of real property, given the state recognizes the property as real property rather than personal property, is eligible to be exchanged for any type of real property, given both properties are located within the United States. Personal property such as aircraft, furniture, livestock, equipment, collectibles, vintage cars, musical instruments, artwork and precious metals are eligible given replaced with like-kind, like-class personal property. Predominate use must be within either the US for US or international for international.
Property not 1031 eligible includes primary residence, partnership interests, debt, inventory and stocks, bonds and securities.
There is no hold time defined in the 1031 code. Revenue Procedure 2008-16 provides a safe harbor such that the IRS will not challenge whether the vacation property is held as an investment if the specified timeframes are met. If one of the facts supporting the exchange is a short hold time, then additional facts must be substantial to eliminate the potential the property was held for resale or flip. One fact may be an unsolicited offer that makes economic sense. To be conservative, a minimum one year and a day hold time is optimal with two years even better, reflecting the intent of the property is for investment rather than as inventory held on the shelf for resale.
1031 Exchange Outcome
The 1031 exchange is used throughout industry by large car, truck and equipment leasing companies to upgrade worn out assets. Hospitals use 1031 exchanges to replace equipment such as magnetic resonance imaging and kidney dialysis machines. Aircraft, artwork, vintage cars, precious metals and collectibles and other personal property held in a trade, business or for investment are taxed at 28 percent rather than real property at 15 percent long term capital gains. Add state capital gains taxes of 9.55 percent in California or 8.98 percent in Iowa, plus 25 percent recaptured depreciation and the tax bill due upon sale can be over 40 percent.
If the intent is to replace with like-kind property rather than cashing out, then a 1031 exchange most likely makes sense. An additional reason to exchange can be to replace a property that does not generate income or cash flow for one that does. Consolidation and diversification represent reasons to initiate a 1031 exchange.
The principal incentive to initiate a 1031 exchange is the indefinite use of an interest free loan. The risk is that the property does not provide the intended benefits or that taxes will be higher when the property is eventually sold. Clearly, estate planning professionals use 1031 exchanges, allowing the tax to receive a stepped up basis to the heirs of the taxpayer, potentially eliminating the deferred tax.
Now that you are familiar with a 1031 exchange, download the complimentary “Do You Qualify for a 1031?” by clicking on the button below.
